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Margin Accounts: A Matter of Risk

Say you’ve been investing for a while and have a little extra cash set aside to try your hand at trading. Retirement and emergency savings accounts aside, this is a pot of money with which you want to get actively involved: from researching your investment options to deciding when to get in and when to get out.

Do you need a margin account for trading? Your broker or brokerage might try to convince you that you do.

But what at first looks like a convenient benefit could actually pose more risk than you can afford.

A margin account is a combination of cash and securities in your portfolio, matched by your broker’s money. If you use the margin funds, you are borrowing money from your broker to increase the size of your portfolio. In a portfolio with stocks and cash, the broker’s margin matches dollar for dollar. So if you have put in $10,000, the margin gives you access to a total of $20,000 to invest.

At first glance, this means you can double your profits, which is a wonderful advantage. However, it also means you double your losses for those holdings that lose value. For example, your $10,000 is matched with margin funds and you now hold $20,000 worth of stock. But the market value drops and your portfolio is suddenly worth $16,000. Now what happens?

The broker will issue you a margin call, demanding that you deposit another $2,000. Why? The maximum limit of margin is 50% of the portfolio’s total value. In the example, your portfolio value fell to $16,000, so the maximum margin is $8,000; but you borrowed $10,000, so now you have to pay back the difference. If you are not able to make the payment, the broker will sell some of your stock to get to their 50% maximum margin level. In fact, that means selling $4,000 out of your portfolio:

Before the margin call

After the margin call

Total value

$16,000

$12,000

margin

$10,000

$6,000

Now you are left with net cash value of only $6,000 out of your original $10,000. To state the obvious: when half of your portfolio consists of borrowed money, your losses hit you twice as hard as losses in a cash-only account.

The rules for margin investing are set by the Federal Reserve Board under “Regulation T.” Maintenance requirements — referring to the minimum cash or securities values you are required to keep in your account — are more complicated. But just considering whether or not to use margin borrowing to invest, remember to look not only at the convenience of “free money” to borrow, but also at the risk. That risk includes not only doubling up any losses, but the added cost of borrowing money. As long as margin balances are outstanding, you have to pay your broker interest. As hard as it is to make a profit from investing just with cash, using margin complicates the task and adds significantly to your overall market risk.

For investors who get into more complex types of investing like the high-volume day trading, margin requirements and rules are also much more complicated. More rules also apply to traders who want to sell short. Finally, margin requirements for some specialized funds are higher than 50%.

Michael C. Thomsett is author of over 60 books, including Winning with Stocks and Annual Reports 101 (both published by Amacom Books), and Getting Started in Stock Investing and Trading (John Wiley and Sons, scheduled for release in Fall, 2010). He lives in Nashville, Tennessee and writes full time.